1、Systemic Liquidity and the Composition of Foreign Investment:Theory and Empirical EvidenceTheory and EmpiricsbyItay Goldstein,Assaf Razin,and Hui TongFebruary 2007The key prediction of the model is that countries that have a high probability of an aggregate liquidity crisis will be the source of mor
2、e FPI and less FDI.The intuition is that as the probability of an aggregate liquidity shock increases,agents know that they are more likely to need to sell the investment early,in which case,if they hold FDI,they will get a low price since buyers do not know whether they sell because of an individua
3、l liquidity need or because of adverse information on the productivity of the investment.As a result,the attractiveness of FDI decreases,and the ratio of FPI to FDI increases.“Imagine a large company that has many relatively small shareholders.Then,each shareholder faces the following well-known fre
4、e-rider problem:if the shareholder does something to improve the quality of management,then the benefits will be enjoyed by all shareholders.Unless the shareholder is altruistic,she will ignore this beneficial effect on other shareholders and so will under-invest in the activity of monitoring or imp
5、roving management.”Oliver Hart.The Efficiency AdvantageThe Disadvantage:A Premature LiquidationHowever,when investors want to sell their investment prematurely,because of a liquidity shock,they will get lower price if they are conceivedby the buyer to have more information.Because,other investors kn
6、ow That the seller has information on the Fundamentals and suspectThat the sales result from bad prospects of the projectRather than liquidity shortage.Liquidity Shocks and Resale Values221)1()()(,1)1(,0)1(),()1)(AKKRGgGGGcdfKFRThree periods:0,1,2;Project is initially sold inPeriod 0 and matures in
7、Period 2.Production functionDistribution FunctionProduction Function:Special FormIn Period 1,after the realization of the productivity shock,The manager observes the productivity parameter.Thus,if the owner owns the asset as a Direct Investor,the chosen level of K is:AEAAAEAK2)1(121)1)(1(1)(*22 Expe
8、cted ReturnIn Period 1,after the realization of the productivity shock,The manager observes the productivity parameter.Thus,if the owner owns the asset as a Direct Investor,the chosen level of K is:AEAAAEAK2)1(121)1)(1(1)(*22 Expected ReturnLiquidity Shocks and Resale Values221)1()()(,1)1(,0)1(),()1
9、)(AKKRGgGGGcdfKFRThree periods:0,1,2;Project is initially sold inPeriod 0 and matures in Period 2.Production functionDistribution FunctionProduction Function:Special FormPortfolio Investor will instruct the manager to maximize the expected return,absent any information on the productivity parameter.
10、AEAAEAK2)21(21)1(1Expected returnLiquidity Shocks and Re-salesAPGdgAdgAPGyprobabilitthresholdDDDDDDD2)1()()1()(221)(2)1()1()()1(2,11112,1Period-1Price is equal to the expected value of the asset from the buyers viewpoint.Productivity level under which the direct ownerIs selling with no liquidity sho
11、ckThe owner sets the threshold so that she Is indifferent between the price paid by buyerAnd the return when continuing to hold the asset DDPDDPPAPAdgAP,1,111,121021)(221If a Portfolio Investor sells the asset,everybodyknows that it does so only because of the liquidity shock.Hence:SinceTrade-off be
12、tween Direct Investment and Portfolio InvestmentdgAdgAAVdgAdgAreturnAPDDDDDDDDDD)(2)1()(2)1()1(2)1()(2)1()(2)1(2)1(1212212122,1If investor does not observe liquidity shock:Ex-Ante expected return on direct investment:Direct InvestmentReturn when observing liquidity shock.Portfolio InvestmentAVAAEAPP
13、P21212)21(21,1When a liquidity shock is observed,return is:When liquidity shock is not observed return is:Ex-ante expected return is:CVVDifCVVDifPDPD)()(Firms sold to Direct InvestorFirms sold to Portfolio Investor01Dif(0)Direct InvestmentPortfolio investment)(CProbability of midstream salesDirect I
14、nvestment)()1(DGResale probability:Portfolio InvestmentResale probability:Only in a few cases,the probabilityOf an early sale in an industry with Direct investment is higher than for An industry owned by portfolio investors.Heterogeneous InvestorsSuppose there is a continuum 0,1 of investors.Proport
15、ion of them have high expected liquidity needs,and proportion have low expected liquidity needs,.HLLH21Different investors face a price whichDoes not reflect their true liquidity-needs.This may generateAn incentive to signal the true parameterBy choosing a specific investment vehicle.rational expect
16、ations equilibriumAssuming that rational expectations hold in the market,has to be consistent with the equilibrium choice of investors between FDI and FPI.thus,it is given by the following equation:FDILFDIHFDILLFDIHHD,DThere are 4 potential equilibria:1.All investors who acquire the firms are Direct
17、 Investors.2.All investors who acquire the firms are Portfolio Investors.3.investors who acquire the firms are Direct Investors,and investors who acquire the firms are Portfolio Investors.4.investors who acquire the firms are Direct Investors,and investors who acquire the firms are Portfolio Investo
18、rs.LLHHAll firms are acquired by Direct InvestorsAdAdAAAdAAPHPPHDHDDHPD2)21(1(2)21()1(2)1(212)21(1(2)21(1)1(2)21(1(2)1(212)21(1(2)21(1)1(2111)21(2221)21(22When investors resell,potential buyers assess a probability of that the investor is selling because of liquidity needs,and a Probability of that
19、she is selling because she observed low productivity.Expected profits,ex-ante,for direct investors exceed expected profits for portfolio investors,for both high liquidity and low liquidity investors:High-Liquidity-needsInvestors:AdAdAAAdAAPLPPLDLDDLPD2)21(1(2)21()1(2)1(212)21(1(2)21(1)1(2)21(1(2)1(2
20、12)21(1(2)21(1)1(2111)21(2221)21(22Low-Liquidity-needs Investors:The two conditions hold for some parameter values!InterpretationThe idea that we are trying to capture with this specification is that individual investors are forced to sell their investments early at times when there are aggregate li
21、quidity problems.In those times,some individual investors have deeper pockets than others,and thus are less exposed to the liquidity issues.Thus,once an aggregate liquidity shock occurs,investors,who have deeper pockets,are less likely to need to sell than investors.LHInterpretationThe reason for th
22、e existence of the pooled,only-FDIinvestment equilibrium is the strategic externalities between high-liquidity-need Investors.An investor of this type benefits from having more investors of her type When attempting to resell,price does not move against her that much,becausethe“market”knows with high
23、 probability thatthe resale is due to liquidity needs.When all high-liquidity-need investors acquire the firms,a single investorof this type knows that when resale contingency arises,price will be low,and she will choose to become a direct investor,self validating the behavior of investors of this t
24、ype in the equilibrium.The low-liquidity-need InvestorsCare less about the resale contingency.As we can see in the figure,the equilibrium patterns of investment are determined by the parameters A and .Since,the value of also determines and thus can be interpreted as a measure for the difference in l
25、iquidity needs between the two types of investors.In the figure we can see that there are four thresholds that are important for the characterization of the equilibrium outcomes.H1LHHLAggregate Liquidity Shocks There are two states of the world.In one state(which occurs with probability q)there is a
26、n aggregate shock that generates liquidity needs as described before.That is,in this state of the world a proportion of one type of investors have to liquidate their investment projects prematurely and a proportion of the other type have to do so as well.In the other state of the world(which occurs
27、with probability 1-q)there is no aggregate shock that generates liquidity needs and no foreign investor has to liquidate her investment project prematurely.probability of an aggregate liquidity shock The intuition is that as the probability of an aggregate liquidity shock increases,agents know that
28、they are more likely to need to sell the investment early,in which case they will get a low price since buyers do not know whether they sell because of an individual liquidity need or because of adverse information on the productivity of the investment.As a result,the attractiveness of FDI decreases
29、.first empirical prediction Countries with a higher probability of liquidity shocks will be source of a higher ratio of FPI to FDI.The Role of OpacityThe effect of liquidity shocks on the composition of foreign investment between FDI and FPI is driven by lack of transparency about the fundamentals o
30、f the direct investment.If the fundamentals of each direct investment were publicly known,then liquidity shocks would not be that costly for direct investors,as the investors would be able to sell the investment at fair price without bearing the consequences of the lemmons problem.Suppose that the s
31、ource country imposes disclosure rules on its investors that ensure the truthful revelation of investment fundamentals to the public.In such a case,FDI investors will have to reveal the realization of once it becomes known to them.Then,since potential buyers know the true value of the investment,dir
32、ect investors will be able to sell their investment at(1+)/(2A).Thus,whether or not a direct investor sells the investment,he is able to extract the value(1+)/(2A),and so the expected value from investing in FDI is(E(1+)/(2A)-C.The expected value from investing in FPI is(1/(2A)as before.This is beca
33、use the kind of disclosure requirements we describe here do not affect the value of portfolio investments.These are requirements that are imposed by the source country,and thus apply only for investments that are being controlled by source-country Analyzing the trade off between FDI and FPI under th
34、is perfect source-country transparency,we can see two things.First,with transparency,FDI becomes more attractive than before.Second,with transparency,the decision between FDI and FPI ceases to be a function of the probability of a liquidity shock.second empirical predictionThe effect of the probabil
35、ity of a liquidity shock on the ratio of FPI and FDI increases in the level of opacity in the source country.Ratio of FPI and FDIProbitDynamic VersionTransparencyData The theory is geared toward explaining the allocation of the shock of foreign capital between portfolio and direct foreign investors.
36、Now we confront this hypothesis with the data.The latter consist of stocks of FPI and FDI in market value,that are compiled by Lane and Milesi-Ferretti(2006).See Summary Statistics.ProbitRatio of FPI and FDILevels of FPI and FDIOpacity IndexEffect of Transparency on Ratio of FPI and FDIProbitRatio o
37、f FPI and FDIInterpretationThe reason for the existence of the only-direct investment equilibrium is the strategic externalities between high-liquidity-need Investors.An investor of this type benefits from having more investors of her type When attempting to resell,price does not move against her th
38、at much,becausethe“market”knows with high probability thatthe resale is due to liquidity needs.When all high-liquidity-need investors acquire the firms,a single investorof this type knows that when resale contingency arises,price will be low,and she will choose to become a direct investor,self valid
39、ating the behavior of investors of this type in the equilibrium.The low-liquidity-need InvestorsCare less about the resale contingency.Figure 2.1:The Allocation of investors between FDI and FPIAggregate Liquidity ShocksSuppose now that an aggregate liquidity shock occurs in period 1 with probability
40、 q.Once it occurs,it becomes common knowledge.Conditional on the realization of the aggregate liquidity shock,individual investors may be subject to a need to sell their investment at period 1 with probabilities as in the previous section.Conditional on the realization of an aggregate liquidity shoc
41、k,the realizations of individual liquidity needs are independent of each other.If an aggregate liquidity shock does not occur,then it is known that no investor needs to sell in period 1 due to liquidity needs.This implies that the only reason to sell at that time is adverse information on the profit
42、ability of the project.As a result,the market breaks down due to the well-known lemons problem(see Akerlof(1970).On the other hand,if a liquidity shock does happen,the expected payoffs from FDI and FPI are exactly the same as in case of idio-syncratic shocks section.The model discussed in the preced
43、ing section assumed effectively that q=1.We now extend the model to allow q to be anywhere between one and zero,inclusive.Figure 2.1 was drawn for the case q=1.When q is below 1,the lines and shift upward;see Goldstein,Razin and Tong(2007).As expected,there is less FPI in each equilibrium and the nu
44、mber of configurations in which there is no FPI rises.In the extreme case where q=0,no foreign investor will choose to make FPI,because there is no longer any liquidity cost associated with FDI,and there remains only the efficiency advantage of the latter.Aggregate and Idiosyncratic Shocks With the
45、predicted probability of liquidity shocks,we can now estimate the regression equation.The results are presented in Table 3.3.Column(b)differs from column(a)in that it does not include the market capitalization variable,as the latter is not available in all of our observations.As our theory predicts,
46、indeed a higher probability of an aggregate liquidity shock(the parameter q of the preceding chapter)increases the share of FPI,relative to FDI.The interaction term between the probability of an aggregate liquidity shock and GDP per capita is significant.This is indicative for a nonlinear effect of
47、the aggregate liquidity shock and/or the GDP per capita on the ratio of FPI to FDI.liquidity crisis We define the liquidity crisis as episodes of negative purchase of external assets.The flow data on external assets is from the International Financial Statisticss Balance of Payments,where assets inc
48、lude foreign direct investment,foreign portfolio investment,other investments and foreign reserves.We thus define the liquidity crisis episodes as sales of external assets,which has a frequency of 13%in our sample of 140 countries from 1985 to 2004.RegressiontitititiobtaGDPpercapiLogobXFDIFPI,1,1,Pr
49、)(Pr)/log(We also include country and time fixed effect variables.The crux of our theory is that a higher probability of an aggregate liquidity shock(the variable q of the preceding chapter)increases the share of FPI,relative to FDI.Therefore we include in the regression a variable,Pi,t+1,to proxy t
50、his probability in period t+1,as perceived in period t.We measure this probability by the probability of a 10%or more hike in the real interest rate in the next period.We emphasize that we look at the probability of such a hike to occur irrespective of whether such a hike actually occurred.Probit To
